The party’s policy review suggests fundamental changes to the public sector – to square the circle of cuts and growth

Once again, the Labour party has tumbled into one of its periods of gloom and introspection. Labour being Labour, it feels more a matter of muted frustration and fatalism than anything particularly energised: we are almost certainly past any talk of leadership plots against Ed Miliband, at any rate. But there is now a widely shared script about the party’s problems, bound up with – among other things – the softness of its poll lead, its underwhelming showing in the local elections, and its ratings for economic competence.

Opinion polling and Kremlinology only tell us some of the story. Across Europe, centre-left politics is in crisis. Towards the end of last week, I had a look at the regular State of the Left bulletin sent out by the thinktank Policy Network, a dependably chilling read that gets more so every month. Only 11% of the French now have a positive view of François Hollande’s policies for growth. The Danish social democrats are on 16% in the polls, and the German SPD is stuck on less than 25%, the same share it managed in 2009. Five years after the short and somewhat delusional boost to the left’s morale that followed the crash, an iron rule of history seems to be asserting itself: that social democracy is something for the good times, and too dangerous a bet for an era as penurious as this one.

Here, the fact that Labour remain the favourite to win in 2015 might suggest a exception. But still: among uncomfortably large swaths of the public, there remains an ingrained – and, it has to be said, completely understandable – belief that Labour’s time in office was a period of profligacy and waste, and so it would prove again. Meanwhile, just to prove it, from the centre of Labour’s ideological continuum leftwards, there is currently an apparent belief that the party can somehow capture power in two years’ time, roll back the worst of the coalition’s cuts, dig out some old A-level notes about Keynesian demand management – and spend, spend, spend.

There are two answers to that. First, you’ll have an interesting job getting any such vision past the electorate. Second, even if you managed to do it, reality would then bite, agonisingly, and the fiscal predicament of the next UK government will be grim beyond words. In all likelihood, it will have to piece through the wreckage of George Osborne’s voodoo economics, fret about unendingly sluggish growth and the consequences for Britain of the seemingly endless euro crisis – and, just to make things really easy, cope with demographic changes (our rapidly ageing population, chiefly) that will make most political and economic orthodoxies completely untenable. In other words, the days when Gordon Brown could deliver budget speeches smattered with millions of this and unending billions of that are over, probably for the rest of most Labour politicians’ lives.

There is, then, a need for new thinking, and quick. Over the past month or so, I have been talking to a few people involved in the Labour policy review being led by Jon Cruddas, which seems to be pointing towards a three-part plan. Whether the leadership will buy in is unclear. The supposed realpolitik that underlies it is often hard to swallow, and many of its assumptions will cause people no end of annoyance, with good reason.But whereas most left responses to austerity are either fantastical or unrelentingly grim, this one has combination of realism and creativity.

The essentials go something like this. Though there will be no reversal of existing cuts, in the context of George Osborne’s howling failure that loud debate about whether to stick to his post-2015 spending plans is completely misplaced. But at the same time, if Labour is to win the next election, it will have to commit to a set of iron, independently enforced fiscal commitments, perhaps to be met over a 10-year cycle, focused not just on the elimination of the deficit, but the ratio of public debt to national income – many of the consequences of which, to quote one Labour insider, could be “brutal”.

Second, the party will need a clear-cut, demand-driven growth plan, based on a housebuilding blitz in particular. And how to square one with the other? The answer leads to the third part of the blueprint: a strong story about radically pruning central government, and pushing power downwards as never before.

I know, I know: this is the Fabianite, lever-pulling, subsidy-junkie Labour party we are talking about. But Cruddas is urging a “radical reconfiguration” of the state and public sector, and he is not joking. He talks about everything from the burden of epidemic mental illness on the prison system to the urgent need to finally tilt the NHS towards prevention rather than cure – and, in order to meet the aforementioned fiscal demands, insists that changes will have to happen fast.

As he has lately been pointing out, if four out of five jobs are brokered with no involvement from local job centres, what does that say about the Department for Work and Pensions (DWP), a swollen and increasingly hateful institution that lately spawned the failed £5bn work programme? There should be cheers for this, and also the idea that Trident replacement – a cool £130bn over 30 years – is an absurd non-starter.

For every £19 of public money spent on housing benefit (total annual cost: £17bn), only £1 goes on the building of homes, and the bill continues to balloon; by much the same token, should we spend so much money on child benefit (about £12bn annually), or shift the focus to dependable childcare? Millions could be saved by timetabling a reduction of working tax credits, and cutting down the state’s grotesque subsiding of big companies’ wage bills.

Were Whitehall to call in and finally audit the huge private-sector contracts that now blanket the entire state, the savings could be towering (the total cost of the ruinous private finance initiative will top £300bn by 2049-50 – not an easy policy matter, though buyouts would suit the basic retrenchment-over-the-long-term agenda).

Woven into the proposals will be a kind of turbo-charged localism. In keeping Labour’s interest in such innovations as regional banks, the basic idea is to seize on a series of pilot projects known as Total Place, aimed at investigating whether pretty much the whole of public-service provision can be administered at an area level, whether focused on town, city or county. Again, the breaking-up of the DWP is relevant here. But so too is that British disease whereby far too many local or regional initiatives have to be signed off and shadowed by those two immense leviathans: the Department for Communities and Local Government, and the Department for Business, Innovation and Skills.

Whirling through all this in a matter of paragraphs hardly does it justice. It requires painstaking work – and on that score, efforts are under way. Aside from the policy review, the Compass thinktank is preparing a high-profile intervention that will make the case for an deficit-driven stimulus alongside “eye-wateringly tight” fiscal rules and an audit of government waste. There are signs – particularly within work on social care – that at least some Labour people are grappling with the huge rethink required. If it materialises, it will be big news; if it doesn’t, the party may have no one but itself to blame for its problems – whether it wins the next election or not.

• This article was amended on 13 May 2013. The original said the State of the Left bulletin was put out by the Policy Exchange thinktank. It is produced by the centre-left thinktank Policy Network.